For the past three weeks, financial markets have been ruled by the unknowns related to the Omicron variant and those surrounding the US Federal Reserve’s monetary policy plans. Now that Fed policymakers have met and have flagged their intentions, optimism appears to dominate. A phrase taught in healthcare comes to mind: primum non nocere, or before intervening, first consider the risk of harm. In the case of central bank policy, this could be read as ‘above all, be sure not to surprise.’
Changing gears for US monetary policy
The conclusions of the latest meeting of the US Federal Reserve’s FOMC (Federal Open Market Committee) can be summarised in a few words:
- A faster reduction of the pandemic-era asset purchases (i.e., accelerated tapering), ending quantitative easing by mid-March 2022
- Flagging three key rates increases in 2022, three more in 2023, and another two in 2024 in the dot plot, or table summarising the levels of rates deemed appropriate by FOMC members.
At first glance, these steps constitute a resolutely more hawkish turn in the Fed’s monetary policy compared to September when the US central bank last published its summary of economic projections and November when it announced initial moves to taper its USD 120 billion/month in purchases of US Treasury bonds and mortgage-backed securities.
Was it really a surprise?
US bond yields ended virtually unchanged after the Fed’s announcement: the 10-year yield was at 1.46% on 15 December after 1.44% the previous day and 1.52% a week earlier. Two-year yields held at 0.66% and were down slightly on the previous week’s 0.68%. These levels may shift in the coming days, but the market’s sanguine reaction combined with a surge in equity valuations does raise eyebrows.
Two explanations come to mind.
On the one hand, Chair Jerome Powell’s comments since his hearing before Congress in late November had prepared the ground, leading the market to expect these announcements.
On the other hand, despite the Fed’s upward revision of its inflation forecasts from 2.3% to 2.7% at the end of 2022 for the core PCE personal expenditure consumption deflator excluding food and energy and the removal of ‘transitory’ from its qualification of inflation, the expected level for the federal funds rate at the end of 2024 is 2.125%. That is below the longer-term (or equilibrium) level estimated at 2.5%.
Is the Fed simultaneously both dovish and hawkish? To reflect this paradox, do we need to start calling it a ‘Schrödinger’s Fed’? Who will open the box to determine which way it is leaning?
Health situation: Still assessing Omicron
With medical authorities forecasting that the Omicron variant, which is at least as contagious as Delta, is likely to become dominant in a few weeks, governments are taking action: they are accelerating vaccine booster campaigns and imposing restrictions on travels.
Investors are focusing on any reassuring news and central banks appear to be minimising Omicron risk, having shifted away from coronavirus as the decisive element in their monetary policy decisions. Initial test results show that three doses of vaccines offer enough protection and there are preliminary indications that patients infected with Omicron are less likely to suffer from severe forms of coronavirus.
Arguably, government decisions to restrict or tighten existing restrictions had already been taken in the face of the fifth (Delta) wave, so even before the emergence of Omicron. Of course, one could worry about another sudden slowdown in global activity. To head off another spike in infections, the health policy focus will be on accelerating booster campaigns.
China: Time for action as growth slows
While developed economies tend to avoid a zero-Covid policy, it remains in force in China and continues to weigh on the economy. It seems unlikely that the authorities will abandon this approach to the pandemic in the near future. Indeed, the Winter Olympics and the National People’s Congress in March could be jeopardised should the epidemic resume.
After GDP growth slowed in Q3, recent data does not show a sharp acceleration of industrial activity. October and November numbers are signalling that consumers have become hesitant.
Thus, it is no surprise that the recent Politburo meeting and the Central Economic Work Conference (CEWC) are indicating a swing to a more proactive economic policy to support investment and confidence.
The CEWC has underlined that ‘stability’ of growth will be a priority in 2022. It specified the three areas of pressures on growth – supply shocks, contracting demand and weakening expectations. These will be addressed in 2022. In an initial move, the People’s Bank of China cut its reserve requirement rate for some banks by 50bp on 15 December. It may decide on a further easing next year.
How are the other economies doing as the year draws to a close?
The cyclical picture is mixed.
US retail sales disappointed in November, but they are 20% above their pre-pandemic level. There appears to be a certain normalisation: After massive purchases of household goods, especially electronic products, consumption could now turn to services. The regional manufacturing survey of the New York Fed improved slightly in December as current conditions improved and new orders rose. Delivery times remain long, but have declined in what could be a first sign of bottlenecks diminishing.
Flash results from purchasing manager surveys for December revealed a slowdown in growth in the eurozone. The composite index fell to its lowest in nine months as a result of a decline in the services index (from 55.9 to 53.3) over health restrictions.
The manufacturing index fell significantly less (from 58.4 to 58) and production rose. Tensions in supply chains appear to have eased.
For now, let’s keep our faith in central bankers and assume we are facing a still positive economic outlook for 2022. It is time to celebrate the end of another eventful year.
The Weekly Investment Update will take a pause before returning in the New Year on 6 January 2022. In the meantime, we wish all our readers a very happy holiday season.
